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What are liquidity pools on DEX and how does it work?

In order for trading and economic activity to take place on DeFi platforms, it must have a stock of assets. While in traditional finance, banks and centralized exchanges are responsible for accumulating assets, on decentralized exchanges, liquidity pools technology performs this task.

What are liquidity pools, how does it work and what role do they play in the DeFi system? Read our article to learn the answers to these questions.

What are liquidity pools?

Liquidity is like the lifeblood of the market. It refers to the availability of assets (such as cryptocurrencies) that can easily be bought or sold without causing significant price fluctuations. When a market has high liquidity, it means that there are many buyers and sellers, which facilitates trading and ensures fair prices.

In a world of decentralized exchanges, where trading takes place directly between users without intermediaries such as banks, liquidity pools play an important role. A liquidity pool in DeFi is a smart contract that is responsible for locking tokens on DEX to guarantee their liquidity. Liquidity providers lend tokens to smart contracts, receiving a reward for doing so.

Roughly speaking, a liquidity pool is a common money bank that allows people to trade cryptocurrencies seamlessly. Liquidity providers contribute their own digital assets to the pool, and these assets are used to facilitate trading on DEX. Liquidity pools are typically created for specific pairs of tokens, such as ETH/DAI or BTC/USDT, where each token in the pair has a certain value in relation to the other.

How do liquidity pools work?

Liquidity pools work on decentralized exchanges and function through the interaction of participants and smart contracts. Let's look at how they work:

Liquidity contribution. Users can participate in a liquidity pool by contributing their tokens to a smart contract on the DEX platform. These tokens are added to the pool's reserves, increasing its overall liquidity. Depending on the portion of the funds provided, each contributor receives LP tokens, which are accrued to the user after the transfer of assets.
Token pairs. Liquidity pools are created for specific pairs of tokens. Each token in a pair has a relative value to the other, which determines the exchange rate within the pool.
Price determination. Instead of relying on a traditional order book, liquidity pools use an automated market making mechanism (AMM). Their role is to automate the process of how traders interact with the pool and display the actual value of coins within the pool. These are smart contracts that calculate the price of a token based on a mathematical formula, often using a constant product model like the popular formula x*y=k from Uniswap, where «x» is the first token entering the pool, «y» is the second token forming a trading pair with the first and also entering the pool (often a stablecoin) and «k» is the total liquidity in the pool, which must remain constant.
Trading with pools. When a user wants to make a trade, he interacts with a liquidity pool. The smart contract automatically adjusts token balances in the pool to maintain the desired price equilibrium. As trades are made, the price of tokens changes according to the supply and demand dynamics within the pool.
Payments to liquidity providers. Liquidity providers — those who contribute tokens to the pool — receive remuneration in the form of fees derived from trading activity. These fees are typically a percentage of trading volume and are distributed to liquidity providers based on their proportional contribution to the pool.
Withdrawal of tokens and changes to the pool. Liquidity providers can withdraw their tokens from the pool at any time. When a user wishes to withdraw his funds from the pool, he will need to burn the existing LP tokens issued during the transfer of assets.

What are liquidity pools used for?

Liquidity pools serve several purposes in decentralized exchanges and token trading. Here are some important applications:

Facilitating token trading. Liquidity pools provide a decentralized marketplace where users can trade tokens directly. They eliminate the need for a central authority or order book, allowing for peer-to-peer transactions.
Increased liquidity. By contributing tokens to the liquidity pool, participants collectively increase the overall liquidity available for trading. This ensures sufficient buying and selling power, reducing the likelihood of price manipulation.
Slippage reduction. Slippage is the difference between the expected transaction price and the actual strike price. Liquidity pools help reduce slippage by providing a pool of tokens that can accept large trades without significantly affecting the price.
Token exchangeability. Liquidity pools allow users to exchange one token for another directly from the pool, without an intermediary. This facilitates efficient token exchange in the DEX ecosystem.
Support for token-related projects. Liquidity pools play a crucial role in supporting newly issued tokens and token projects. By providing liquidity to these tokens, liquidity pools facilitate their initial trading and market opening.
Opportunities for profit generation. Liquidity providers can earn additional rewards by participating in liquidity or yield mining programs, where they bet their pool tokens to earn additional tokens or incentives offered by the DEX platform.

Types of Liquidity Pools

Liquidity pools serve a variety of purposes beyond facilitating direct peer-to-peer token trading. For example, the developers of the Curve decentralized exchange realized that the mechanism offered by Uniswap is not well suited for exchanging assets whose price should not change, depending on supply or demand. That's because they are backed by real assets, like the U.S. dollar. This type of asset, in particular, includes stablecoins such as USDT, TUSD, USDC and others. Curve pools operate on a modified algorithm that has reduced sensitivity to each individual transaction and the exchange rate remains more stable. This demonstrates that liquidity pools adapt to different asset types and can be tailored to meet specific needs.

In addition to automated market trading (AMM), which is the underlying concept of liquidity pools, there are other types of liquidity pools:

Liquidity mining or farming. This concept, also known as yield farming, has gained popularity as a way to earn passive income. Users can participate in liquidity pools and earn additional tokens or incentives provided by the DEX platform as rewards for providing liquidity. Liquidity mining encourages users to contribute their tokens to the pool and maintain the liquidity ecosystem.
Blockchain startup management. The concept of a liquidity pool can be used for decision-making processes within blockchain ecosystems. For example, users can participate in governance and voting by placing their tokens in the liquidity pool.
Coining synthetic tokens. Liquidity pools can also be used to mine synthetic tokens. Synthetic tokens are a digital representation of real assets or other cryptocurrencies.

Pros and cons of liquidity pools

Liquidity pools offer various advantages to users, however, they are not without disadvantages. Let's take a look at the pros and cons associated with liquidity pools.

Pros of Liquidity Pools

Increased liquidity. Liquidity pools pool tokens contributed by multiple participants, resulting in increased trading liquidity. This reduces slippage and improves the overall trading experience.
Decentralized trading. Liquidity pools operate on DEX, allowing users to trade tokens directly without relying on intermediaries or centralized platforms.
Liquidity providers' fees. Liquidity providers can receive rewards in the form of commissions derived from trading activity. These rewards encourage users to contribute their tokens to the pool and participate in the development of the platform.
Flexibility in token exchange. Liquidity pools allow users to exchange tokens directly within the pool, providing flexibility in accessing different assets without the need for a counterparty.
Opportunities for passive income. Some liquidity pools offer additional incentives, such as yield farming or liquidity mining programs that allow users to earn additional tokens or rewards by betting on pool tokens.

Minuses of liquidity pools

Non-permanent losses. Liquidity providers face the risk of volatile losses, which arise when the value of tokens in the pool differs from their value if they were outside the pool. Price volatility can lead to temporary losses for liquidity providers.

Dependence on smart contracts. Liquidity pools rely on smart contracts to manage the exchange of tokens and the distribution of rewards. Any vulnerabilities or security flaws in the smart contract code could result in financial loss or disruption.
Limited control over trading decisions. Liquidity pool participants have limited control over trade execution because they rely on the pool's pricing algorithm and trading mechanisms.

How to use a liquidity pool

Liquidity pools offer users the opportunity to earn income within the DeFi ecosystem. Here's a guide on how you can make money from liquidity pools:

Choose the appropriate platform. Research and select a reputable DEX platform that supports liquidity pools (such as Uniswap, SushiSwap or Curve).
Choose the right pool. Identify the liquidity pool that supports the trading pairs or assets you want. Common pools include stablecoin pairs and popular cryptocurrencies. There are also specialized pools for specific tokens.
Provide liquidity. To make money from liquidity pools, you need to contribute your tokens to the pool. To do this, you need to contribute an equal value of both tokens to the trading pair. For example, if you want to provide liquidity for an ETH/DAI trading pair, you must contribute equal amounts of ETH and DAI to the liquidity pool.
Receive trading fees. As a liquidity provider, you receive a portion of the trading fees generated by the liquidity pool. These fees are paid by traders who use the pool to exchange tokens. The more liquidity you provide, the higher your share of the trading fees.
Explore additional incentives. Some liquidity pools offer additional ways to make money. These may include participation in liquidity mining or yield cultivation programs.
Monitor and adjust. Monitor your liquidity pool investments and evaluate their performance regularly. Market conditions and demand for specific trading pairs may change over time, affecting the profitability of your liquidity pool.
Consider risk factors. Keep in mind that there are risks associated with liquidity pools, such as non-permanent losses and exposure to token volatility.

Liquidity pools are one of the fundamental elements of the DeFi environment. They embody the main idea of decentralization and freedom of access to finance. Pools allow users to trade directly with a smart contract without waiting for third-party permission. Anyone can contribute to a liquidity pool. This initiative brings rewards, often many times over. However, you should be careful in your choice of pools.